Research Journal of Finance and Accounting www.iiste.org ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol.5, No.3, 2014
Using Loan-to-Deposit Ratio to Avert Liquidity Risk: A Case of 2008 Liquidity Crisis
Muhammad Sajid Saeed Glasgow Caledonian University, Cowcaddens Rd, Glasgow, Lanarkshire G4 0BA, United Kingdom E-mail: email@example.com
Liquidity risk is an on-going issue since the emergence of liquidity crisis of 2008. This paper aims to contribute to the discussion on how Loan-to-Deposit (LTD) ratio can be used to investigate and avert liquidity problem in the banking sector. For this purpose, the data of Major British Banking Groups (MBBG) are collected and critically analysed. The findings of the study reveal that the banks which sustain the LTD ratio were able to successfully pass through the liquidity crisis of 2008, and other banks which rely more on borrowed funds or banks with increasing LTD ratio, became the victim of financial crisis.
Liquidity crisis, Loan-to-Deposit ratio, LTD, solvency, financial crisis, UK banking sector
The success of any business is largely based upon its liquidity power. Crucial decisions are made in financial market based upon liquidity position. Bhattacharya (2004) defines liquidity as “a firm can maintain liquidity if it holds assets that could be shifted or sold quickly with minimum transaction cost and loss in value” (p. 281). He further added that a firm’s liquidity can be measured by its ability to meet its cash obligations when they are due and to exploit sudden opportunities in the market. Liquidity crisis is a broad term applied to various types of situations where banks lose their huge part of the value suddenly. The liquidity crisis began with the bankruptcy and bailouts of big market giants and spread like a flood & gathered intensity in 2008. In the early 2009, global economy and financial system appeared to be locked in a descending spiral (National Audit Office, 2009). Liquidity crisis mainly emerged in the world’s banking sector in the early 2007 due to the wrong policies of mortgage lenders. According to Caouette
(2008) “the liquidity crisis occurs whenever a firm is unable to pay its bills on time or lacks sufficient cash to expand inventory and production or violates some term of an agreement by letting some of its financial ratios exceed limits” (p. 546). The bankruptcy and bailouts of giant companies such as Lehman Brothers, Citigroup, Merrill Lynch, Bear Stearns, AIG, and Freddie Mac have brought difficult time for world’s economy, financial systems, and central banks. The variety and volume of negative financial news have lifted up new questions about the market mechanism and the origins of the financial crisis by which they are propagated. Fisher
(2008) believe that the liquidity crisis emerged due to eruption in credit market turmoil. In addition, banks and other financial institutions were failed to absorb liquidity after providing easy access to credit with relatively low interest rates. According to Ackermann (2008), in the beginning of the financial crisis UK monetary policies gave rise to global liquidity which was attached with the exchange rates. In the meanwhile, the subprime mortgage crisis emerged when UK housing market was affected due to lack of mortgage financing. On the other hand, the refinancing of off-balance sheet vehicles put more pressure on bank’s liquidity (Gibson, 2008). The literature evidence reveals that the impacts of liquidity risk on the profitability of bank is of mixed nature. According to some experts (e.g. Molyneux and Thornton, 1992; Barth
. 2003) liquidity risk has a positive impact on profitability of banks. On the other hand, Kosmidou
(2005) believe that it has a negative impact. In reality, no detailed work has been carried out on liquidity and its impact on banking operation.
2. Literature review
2.1 Importance of liquidity for banks
Traditionally, it is believed that banks exist to create liquidity from illiquid assets and it is also known that bank’s success or failure is based on liquidity risks (Diamond and Dybvig, 1983). Besides, the study of liquidity risk is important for the banks in terms of determining their profitability or interest margins (Kosmidou
2005). In the past, experts mainly focused on measuring credit and operational risks and often ignored liquidity risk measures. However, it is clear from the recent financial crisis that liquidity risk is an important issue in